Ceat - Demerger Likely

Ceat has brought in cost efficiencies in operations and its investment arm demerger and land sale will bring in a cash pile.

After reeling under rising cost of raw materials and attendant competitive cost pressures which had whittled margins, tyre majors are reaping benefits of cost optimisation and dipping natural rubber prices.

SHORT TERM GAINS
Rs/share	FY 08
Ceat's core business	132.00
Value of investment arm	26.00
Land value	12.10
Total	170.10

One such tyre company that has seen its operating margins move from under 4 per cent five quarters ago to a healthy 9.2 per cent in the current quarter is Ceat. With short-term triggers coming from non-core areas such as sale of land and demerger of its investment arm, the stock could see a rerating.

Unlocking value

Ceat wants to shift its 31-acre manufacturing facility located in Bhandup, Mumbai to a new location and sell the land to real estate developers. As a first step, the company has identified 6.5 acres which will be sold by the third quarter of the current fiscal. At Rs 14 crore an acre, the land is expected to fetch Rs 91 crore.

By FY09 when the entire facility will be shifted out to Patalganga and the entire land is sold, the company is expected to pocket nearly Rs 400 crore. The company is also demerging its investment arm, CHI Investments into a separate listed entity and this too is expected to boost the stock price.

Investment gains

CHI Investments has exposure to stocks of RPG group companies and has an investment value of Rs 127 crore. The current market value of these investments is put at nearly Rs 400 crore. According to the financial restructuring, existing shareholders will get one share in CHI Investments and three shares in the new Ceat for every four shares held in Ceat holding in the new entity.

In addition to these, the company is also expected to make an octroi saving of Rs 28 crore (in the event octroi is abolished), and has received refunds from income tax and Sicom to the tune of Rs 15 crore and Rs 8 crore respectively.

These are all windfall gains, and are mostly of a one-time nature. But besides these, the company has put in place plans to move into higher value-added products and improve realisations.

Value-added portfolio

To tackle increasing cost pressures and cut-throat competition, Ceat adopted a three-pronged strategy to improve margins. Ceat's vice president Amit Kumar says that the company changed its product mix, went up the product value chain and outsourced low-end manufacturing activities.

Of Ceat's three segments, OEM, replacement and exports, realisations from supplies to auto manufacturers historically were 15-20 per cent lower than Ceat's largest revenue earning segment - the replacement market which accounts for 62 per cent of sales. High demand and lack of supply has put Ceat at an advantage and the difference is now only 5-10 per cent, which has boosted margins in the past quarter.

The company is aggressively scouting for more opportunities in the export markets which account for 20 per cent of sales and come with higher realisations of Rs 18 per kg. The company's focus on exports and replacement could not have come at a better time, according to Kumar as Ceat's OEM sales are expected to dip by 20 per cent because of the slowdown.

The company is also trying to shake off the tag that it caters primarily to the economy segment by including high-end products in its portfolio. Says Kumar, "Ceat is looking at speciality tyres -- be it radials which have realisations of Rs 100 per kg or off-the-road tyres where it has doubled its capacity with a investment of Rs 47 crore in the last fiscal and saved on costs with in-house mixing."

In line with its aim of moving up the value chain, the company is outsourcing low-end tyre manufacturing activity for scooter, motorcycle, auto rickshaw and agricultural application tyres. This has freed up capacity to focus on high margin products and at the same time reduce costs.

The company is planning to relocate its 240-tonne Bhandup plant to Patalganga which will have an enhanced capacity of 300 tonne of which 100 tonne would be for manufacturing specialty tyres. The capacity at its Nashik facility has been enhanced to 180 tonne from 140 tonne.

The cost of the Patalganga facility is expected to be Rs 300 crore which is to be funded by internal accruals and debt in a 1:1 ratio. To make deeper in-roads in the radials business, the company plans to set up a greenfield facility to manufacture passenger car radial facility along with truck and bus radials. The production facility, the location for which has not been finalised, is expected to come on stream by FY11.

Efficiency gains

The company's focus on cost cutting is paying off. Interest, depreciation and manpower costs are down from nearly 20 per cent of sales to half that number over the last seven years even though the top line has nearly doubled during this period.

Says Kumar, "Costs are down thanks to value engineering which involved the use of low weight tyres and material substitution based on natural and synthetic rubber prices."

The key raw material for the company is natural rubber which accounts for 46 per cent of its raw material cost while crude oil by-products synthetic rubber (8-12 per cent), carbon black (20 per cent) and nylon cord fabric (15 per cent) account for the rest.

The company changes this mixture and uses arbitrage opportunities between domestic and international prices to bring down its raw material costs. This helps balance the cost differential as natural rubber is seeing a declining trend while crude prices are going up.

Valuations

Since most holding companies trade at a 50-70 per cent discount to their investment value, Ceat's holding arm, which has investments of Rs 400 crore, would work out to Rs 26 per share. After deducting Rs 12 per share of the land value as well, Ceat's core business trades at a P/E of about 9.8 times estimated FY08 earnings.

With a 40 per cent net profit growth, analysts say the P/E of the core business could get re-rated up to 12 times, thus valuing the share at Rs 170. If its invested companies like KEC International, CESC and Phillips Carbon Black rise further or if the holding company discount is not as low as 70 per cent, there could be further upsides.